Digital Switch: Everything But Digital Switches

Investors who believe in red herrings, blue sky, 500-to-1 shots and building a better mousetrap can find everything they are looking for in a McLean company called Digital Switch Corp.

Digital Switch also has a lesson to teach about what "full disclosure" means in a town where the phrase often is used as the equivalent of telling people things you are afraid they will find out anyway.

Not so at Digital Switch -- not after the Securities and Exchange Commission caught two Washington stock brokers selling unregistered stock in the company and charged them with fraud.

Brokers Charles W. Marmon and Harry E. Hagerty Jr. also happened to be founders of Digital Switch, a fact Hagerty neglected to report either to the SEC or to the firm he worked for, John Muir and Co.

Nor did Hagerty or Marmon tell investors that Digital Switch has spent $1.2 million in four years -- and has yet to build its first switch.

To settle the SEC charges, Digital Switch agreed to accept a unique punishment: The company kicked out Marmon as chairman and removed Hagerty from the board of directors. It also promised to offer everybody who bought the stock their money back, plus interest. And the company promised to register the stock and tell the truth about its prospects and problems.

The result was the publication this month of what may be the most unusual prospectus offering stock ever written. Stock brokers call these offers of new stocks "red herrings" and usually for good reason.

But nobody's likely to be thrown off the scent by Digital Switch's prospectus. Every skeleton in the company's closet is on view. By actual count there are 25 of them -- nine different "special risk factors" and 16 more "high risk factors" spelled out in detail.

Digital Switch is offereing to sell 2 million shares of stock for $5 a share. That turns out to 500 times what each share is worth since the remarkably candid prospectus reveals that two different appraisers evaluated the shares at less than a penny apiece.

"These securities should not be purchased by investors needing a return on their investment or who cannot assume a total loss on their investment," the offering statement warns on its cover.

That story is quite different than what Marmon and Hagerty told would-be investors, the SEC said. The two claimed the value of the shares would "increase dramatically." They said a three-for-one stock split was imminent and buyers could triple their investment.

The two brokers, who were getting 10 percent of all the money they raised selling Digital Switch stock, said the company's first product would be ready for testing early in 1978. "Significant orders from major carriers" were coming "in the near future," the two said, predicting that in 1980 the company would sell $9.5 million worth of digital switches and make a profit of $1.4 million.

In reality, the prospectus discloses, the company had lost $3,150,000 as of April 30, has no orders and has not even completed building its first switch.

What Digital Switch is trying to do is build a better mousetrap for telephone companies. The company was incorporated in 1976 to develop a solid-state replacement for the electro-mechanical switches that do all the work when a telephone call is dialed.

It already has built five of the 30 printed circuit boards needed for the switch. Another 20 are literally on the drawing board and engineers are working on the rest.

Even when the switch is completed, there is no assurance it will work, the prospectus says. It also admits that Digital Switch has neither the manufacturing capability to make the devices, nor the marketing expertise to sell them. Neither the Bell system nor General Telphone -- together accounting for 87 percent of the telephone equipment market -- are expected to buy them.

Plenty of other high-technology companies have sold stock based on blue-sky promises about an incomprehensibly sophisticated product, so that aspect of the Digital Switch story is not unique.

Like many such companies, Digital Switch was started by a couple of engineers and a couple of money men. The technical guys were John S. Edwards and Theron M. Randall, who worked for Data Transmission Co. (Datran) before founding Digital Switch with Marmon and Hagerty.They soon brought in another Datran man, Edvin Farinholt, as president.

Edwards, Randall and Farinholt were ousted in 1978 after they proposed selling the business to a French phone company and were overruled by Marmon and Hagerty.

The two stock brokers raised much of the money for the enterprise by selling stock to their regular customers. The SEC charged Hagerty failed to disclose his ties to Digital Switch as required by law. He claimed in court he was not trying to hide anything but that his secretary retyped an old report to the SEC and neglected to include his latest venture. Last August he paid a $5,000 fine for the violation.

Both men later were charged with fraud for not revealing details of Digital Switch's financial operations to investors and for selling unregistered securities. As is standard practice in SEC complaints, both signed consent orders promising not to violate the law again, but not admitting to any wrongdoing.

Marmon has had troubles with the SEC before. He was a partner in Washington Investment Planning Company until 1973, when the SEC charged the firm with violating its minimum financial requirements. For that, the SEC banned Marmon from being a principal in a securities firm for three years.

Marmon and Hagerty had more record-keeping problems at Digital Switch. The company was too small to use either preprinted or prenumbered stock certificates, so each time shares were sold, a certificate had to be written up.

Along about certificate number 144, somebody goofed. The company's records do not show who bought certificate 144. The prospectus calls it "a clerical error" and suggests someone accidently skipped a number.

But in case some investor is holding that certificate and might show up later to claim an interest in the company, Marmon and Hagerty have been ordered to put up 200,000 shares of their own Digital Switch stock to protect the other shareholders.

Digital Switch also made the mistake of giving some people stock as payment for services, a practice prohibited by the company's own articles of incorporation. The company was forced to reclaim 189,000 shares of stock. The people who had to give back the stock then were given a chance to purchase valid shares for a penny each, and all of them took the offer.

Several sales of stock to insiders at prices far below the $5 price being charged to the public are detailed in the offering statement. The insiders have paid an average of $1.44 a share for their stock, putting up a total of $2.9 million. They control 51 percent of the stock.

Public buyers will have to pay $5 a share, a total of $10 million, for the remaining 49 percent.

After the sale, the insiders will get an immediate gain in the value of their investment of $4.4 million, or $2.16 a share, and the book value of the public investor's shares will be diluted to $2.22.

The company says it plans to use $500,000 from the stock sale to set up a fund to protect its officers and directors from future lawsuits resulting from the company's tangled finances. The SEC, however, has already warned the company it does not consider that a proper use of coporate funds. So the first legal battle the company will have to fight could be with the SEC, which has already set several revealing precedents in the Digital Switch case.